August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Financials
Bank/ Large Caps
J.P.MORGAN CHASE – THE MEGA BANK
_______________________________________________________________________
Bhavik Kothari
MBA 04 – The Ohio State University
JPM
NYSE
$38.00
Email: kothari.23@osu.edu
Current
Buy
Risk
Low
Tel no: 614 571 0407
Key Statistics:
Current Market Price
52 Week Trading Range
Current EPS (ttm)
Trailing PE
Target
Industry
$ 38.00
$33 – 43.84
$ 2.312
15.00
Market Cap
Shares Outstanding
Dividend Yield
ROA and ROE
$56.28
Banking
$ 137 Bln
3.5 Bln
3.58%
0.83% /
13.06%
Summary:
i.
Merger to act as a positive catalyst: Synergies in operations and diverse mix
of non-interest income will help in improving the profitability of the merged
entity in the long run. We expect the operating margins and return on equity
to improve as a result of efficient management of operations and a stable noninterest income.
ii.
Net interest margins are deteriorating and are not expected to improve:
JPM is facing pressure on the interest earned on loans and interest cost of
liabilities. As a result of this, its net interest margin is facing intense pressure.
The merger with ONE is not expected to bring synergies to the net interest
margins and hence margins are not expected to improve.
iii.
Further mergers down the road if the current trend holds good: JPM is in
a mature stable industry, which is still very fragmented and we do expect that
with JPM’s deposit market share much lower than the mandatory 10% cap,
there might be more acquisitions down the road. This further helps in
increasing market share, improving franchise value and driving profit
margins.
iv.
Valuations are attractive: The current valuations are very attractive when
measured on an absolute basis. The intrinsic value as per the Dividend
Discount Model and the Diamond Hill Investment Model indicate that the
stock is trading at a significant discount with adequate margin of safety.
Key Conclusion:
Based on the issues identified above (which are also discussed in detail later) we
recommend a BUY decision on the stock.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
I. INDUSTRY ANALYSIS:
To analyze the banking industry, it is important to analyze its secular and cyclical trends.
It is also pivotal to analyze each component of the banks’ financial statements and
identify the key economic drivers behind each component. We shall first start with
analyzing the merger trends in the banking industry. Then we will move to the analysis
of different types of loans and leases such as mortgage loans, consumer loans and
commercial loans. We will then reflect upon the banks’ liabilities and analyze the trends
and the fundamental factors that drive the trends. We then conclude the industry analysis
by evaluating the profitability trends that comprise of net interest margins, non-interest
income and efficiency ratios.
Merger related trends in the banking industry:
Historically due to regulatory obstacles, the banking industry remained fragmented
for a long period of time. However in the past 20 years, there has been a substantial
decline in the number of organizations and growing concentration of assets in the
hands of a few banking organizations. Since 1984 to 2003, the number of banking
institutions has fallen from 15,084 to 7,842, a decline of 48%1. 73% of the banking
assets are now held by banks with assets greater than $10 billion. Previously in 1984,
only 42% of the assets were held by these banks. In case of deposits 25% of all the
banking deposits are now held by three major banks; Bank of America, J P Morgan
and Citigroup Inc.
As per a study done by Prudential Equity Group, the top ten banks hold 38% of the
deposit market share, an indication that fragmentation in the industry still exists.
Besides Bank Of America, which has reached its mandatory 10% cap on deposits, the
second and third largest bank hold 6.9% and 4.5% of the deposit market respectively.
This indicates that further consolidation among banks cannot be ruled out.
So what is the future expected structure of the banking industry. This topic has been
thoroughly studied in the academic and real world. Although there seems to be a
consensus on the factors that drive the consolidation of the banking industry, many
researchers have used different techniques to predict the rate of decline in the number
of banking institutions. These studies have ranged from linear extrapolation of past
rates to scenarios and probability analysis.
Kenneth D. Jones and Tim Critchfield in their study have criticized the approach of
linear extrapolation as it fails to recognize the underlying forces behind the trend and
how they may or may not hold good in future. Shull and Hanweck (2001) in their
study, observed the rate of change in the banking organizations. They believed that
the industry in 1984 was in a state of equilibrium. Then came the regulatory and
technological forces, which acted as an exogenous shock to disrupt the equilibrium,
and cause the number of banking organizations to decrease. The following diagram
and the trend line explain this phenomenon. The rate of decline in the banking
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
organizations first increased at an increasing rate till 1992 and then at a decreasing
rate to (-) 0.5% in 2003. Going by the current trend, the industry will regain its
equilibrium in the next five years, at time when the number of organizations will be
7250 (still fragmented).
We believe that the above studies have major shortcomings. Although it is important
to identify changes in the number of organizations, it is also important to gauge the
changes in the level of concentration in the industry. Second the study also ignores
the fundamental forces that have been forcing mergers among the larger banks.
Slow growth rates in commercial and industrial loans, commoditization of credit,
competition in deposits pricing, deteriorating net interest margins, diversifying to a
wider base of income from non traditional sources, synergies in operations and
economies of scale are some of the main fundamental forces that are driving the
consolidation. The question we should ask ourselves is whether any of these factors
have changed or are expected to change in the near future. Is there any economic
catalyst apart from regulatory changes (anti trust) that can disrupt this trend? While
we agree that in future the US banking industry will still be fragmented in terms of
the number of organizations, we do believe that the industry will become more
consolidated in terms of assets and deposit market share due to the driving forces
created by the factors mentioned above.
Loans and Leases:
i. Real estate loans and advances:
Real estate loans form a major component of the bank’s total loans and leases. In the
past twenty years, the contribution of mortgage loans to the bank’s earnings has
increased considerably. Since banks faced intense competition from the enhanced
capital markets activity on the commercial loans side, they shifted their focus and
diversified their exposure to mortgage loans. Although they are low interest earning
loans, they are fee intensive and are considered safe due to the collateral aspect.
The following chart presents the residential mortgage loans outstanding during the
period 1973 to 2003. The residential mortgage debt outstanding for all US
commercial banks increased from approximately $ 113.00 billion in 1973 to $ 1,960
billion in 2003.
Now let us identify the key economic factors that drive mortgage loan growth;
interest rates, personal income growth and changes in home ownership rates.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
(Data obtained from FDIC, Federal Reserve, MBA - $ in Billions)

Interest Rates - 30-year mortgage rates:
(Data obtained from FDIC, Federal Reserve and MBA)
As can be seen from the chart above, the 30-year mortgage rate doubled from 8%
to 16% during the period 1973 to 1982 and since then the rates have been on a
secular decline till 2003, when rates reached a low of 5.8%. Although cyclically,
the rates have correlated with the interest rate environment, the movement in
interest rates has not had a significant impact on the secular trend of the mortgage
loan growth.
Rising interest rates does hurt the refinancing activity of the banks as borrowers
are discouraged to refinance their debt for higher interest rates. Although this
slows the mortgage refinancing activity, it increases the interest income generated
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
from higher interest coupons. Conversely when rates fall, interest coupons fall
but the refinancing activity increases. At present when we are in a rising interest
rate environment, mortgage-refinancing activity will definitely be negatively
affected but first mortgage loans will follow the secular increase due to the rise in
personal income levels and homeownership rates.
From a statistical standpoint, changes in mortgage rates have not had a significant
impact on residential mortgage loan growth. Hence to merely conclude that a rise
in interest rates can prove disastrous for mortgage activity is far from correct.

Personal Income:
The following chart shows the trend in the personal income levels in the US.
Personal income levels increased from $ 1.1 trillion to $ 9.2 trillion during the
period 1973 to 2003.
Personal Income
$10,000
$8,000
$6,000
$4,000
$2,000
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$0
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
We regressed the mortgage loans outstanding for each year against the personal
income levels and found that there was a high degree of correlation between these
trends. The regression results are presented below:
Regression Analysis
Mortgage Loans
O/S
2,500
y = 0.2066x - 277.62
R2 = 0.9569
2,000
1,500
1,000
500
-
2,000
4,000
6,000
Personal Income
8,000
10,000
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Personal income growth is one of the key factors in driving mortgage loan
growth, showing a correlation of 0.96.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________

Homeownership rates:
The following chart presents the secular trends in the US homeownership rates.
Homeownership rates have been on a secular increase from 64% in 1973 to 65.5
% in 1980 and then dropped and stayed at 64% till 1994 before showing a steady
increase to 68.5 % till 2003. Although during the period 1974 to 1994, the
homeownership rates had very little or no correlation with the trends in mortgage
loans, we believe that since 1994 the rise in the homeownership trends played a
crucial role in mortgage loan growth.
Homeow nership Rates
69.00
68.00
67.00
66.00
65.00
64.00
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(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: From the above analysis, we conclude that personal income growth
and homeownership rates are the key economic drivers for mortgage loans.
Mortgage rates do affect refinancing activity, but not first mortgage loans and
hence its overall effect is not so significant. Since the secular trend of increasing
personal income growth and homeownership rates is expected to continue as the
economy picks up steam and employment growth takes place, we predict that the
mortgage loans can grow at its long-term average rate of 9.4 % for the next five
years. This is still much lower than the growth rates in the recent years and hence
quite conservative.
ii. Consumer Debt:
Another segment that has been a major growth area for commercial banks is the
consumer debt segment. Consumer debt of which the main components are credit
card debt and auto loans, increased from $ 17 billion in 1955 to $ 770 billion in
2003. Let us now evaluate the key economic factors that can drive consumer
debt; personal consumption levels and interest rates.
We regressed the personal consumption levels in the US against consumer debt
outstanding for each year during the period 1955 to 2003. The following graph
presents the regression results. There is a high correlation (0.98) between
personal consumption levels and consumer debt outstanding.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Consumer Debt
Outstanding
Regression Analysis
900
800
700
600
500
400
300
200
100
-
y = 0.0925x + 11.929
R2 = 0.9861
0
2000
4000
6000
8000
10000
Personal Consumption
(Data obtained from FDIC, Federal Reserve, BEA and MBA - $ in Billions)

Another factor that might be considered a key driver to consumer debt is the
interest rate environment. It is feared by many that with the expected increase in
interest rates, consumers will be discouraged to take on more debt and hence
consumer debt revenues might fall. When we regressed the consumer debt with
the level of interest rates for the past 49 years, we did not observe any significant
correlation between these factors. The regression results are presented in the
following chart.
(Data obtained from FDIC, Federal Reserve, BEA and MBA - $ in Billions)
Hence we can conclude that consumers tend to base their debt taking decisions on
employment growth and growth in personal income. These factors mainly drive
their consumption decisions and hence the willingness to take on more debt.
With the economy on its path to recovery, we can expect to see an increase in
personal income levels and robust employment growth. These factors should only
increase consumption and act as a positive catalyst towards consumer debt
revenues.
iii. Commercial and Industrial Loans:
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
The third and the most important component of the asset side of a commercial
bank is the commercial and industrial loans. The following chart presents the
trends in the total industrial production and commercial and industrial loans
outstanding for the period 1986 to 2003. Total industrial production has been on
a steady rise from 1.8 trillion in 1986 to 2.8 trillion in 2004 a CAGR of 3.3%.
During the same period, commercial and industrial loans increased from 500
billion in 1986 to 880 billion in 2004 growing at a compounded annual rate of
4.3%.
As seen from the chart, C&I loans have mirrored the growth in industrial
production except in the last 12 – 18 months. Although there has been a pick up
in industrial production, C&I loans have yet to show any signs of growth.
(Data obtained from FDIC, Federal Reserve, BEA and MBA - $ in Billions)
3,500.00
Total Production
3,000.00
C&I Loan O/S in $ Bil
2,500.00
2,000.00
1,500.00
1,000.00
500.00
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
-
The answer to this issue can probably be found in the second graph shown as
follows. The graph presents the total and manufacturing capacity utilization index
for the period 1986 to 2004. Although in the past 12 months there has been a
surge in capacity utilization levels, it is still quite lower than the high levels of
capacity utilizations in the 1990s.
90.00
85.00
80.00
75.00
70.00
Manufacturing Capacity
Utilization Index
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65.00
Total Capacity Utilization
Index
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
This indicates that corporates are still quite reluctant to invest in expanding
capacity as they are still trying to make use of their existing capacity. If the
economy sustains its growth and if industrial production expands, companies will
have to invest in increasing their manufacturing capacity for which there will be a
need to borrow.
Conclusion:
Since the capacity utilization levels are still quite lower than those seen in the
1990’s, we do not foresee significant pick up in C&I loan growth in the near
future. We do not expect that C&I loans will grow at a historical CAGR of 4%.
Considering the low levels of capacity utilization and a growth in productivity, we
predict that C&I loan will grow at a modest rate of 2.5% for the next five years.
iv.
Trend analysis of different loan segments:
The following chart presents the trends in the composition of the bank’s earning
assets during the period 1966 to 2003. Two major trends have emerged in the last
16 years from 1987 to 2003.
The proportion of C&I loans as a percentage of total earning assets has decreased
considerably from 40% in 1983 to less than 20% in 2003. Mortgage banking
segment has grown from 24% of earning assets in 1966 to more than 50% in
2003. This is the most striking trend especially in the 1990s when this segemnt
surpased C&I loans to become the largest loan and leases segment. What are the
factors that have caused this secular trend?
C&I loans have been under pressure mainly because of the increase in the capital
market activity. Due to the technological advances and sophistication on Wall
Street, corporates have been able to access capital markets themselves and issue
short and long term bonds. As a result of this, banks have lost their market share
in this loan segment. Recognizing this trend, banks have shifted their focus to
mortgage banking, which is a growth segment due to personal income growth
and rising homeownership rates.
Trend Analysis of different loan segments
Consumer Loans
Real Estate Loan
C&I loans
Other Loans
60%
40%
30%
20%
10%
0%
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% Weights
50%
Year
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: We do not expect any significant change in these trends for the next
five years. Banks that have recognized and shifted their focus to the faster
growing segments will benefit from this trend. At the same time, banks which
still focus on C&I loans will see their business and net margins decline.
Deposits:
The first chart below shows the trends in total deposits, personal income of
individuals and personal consumption levels from 1988 to 2002. The second
chart presents the trends in personal savings and corporate profits during the
period 1988 to 2002. Personal income and consumtion has been increasing at a
CAGR of 7.4% and 8.4% respectively. As a result of this, the personal savings
have been on a secular decline reflecting a negative CAGR of 4.4%. Corporate
profits have also increased at a CAGR of 8.9%. These trends collectivly explain
the slower growth in deposits over this period. Deposits have grown at a CAGR
of 6.4 %, tempered due to the decrease in personal savings rate.
Deposits
Income
Consumption
Trends in deposits
Trends in personal savings and corporate profits
Saving
Corp Profits
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
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600.00
500.00
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100.00
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(Data obtained from FDIC, Federal Reserve, BEA and MBA - $ in Billions)

Analysis of non interest bearing deposits
The following chart presents the composition of non interest bearing deposits as a
percentage of total banking deposits. The % non interest bearing deposits have
been on a secular decline, falling from 55% to 20% during the period 1966 to
1986. Since then the weight has been constant at around 20% of total deposits.
The main reason for this delining trend has been the intense compeition among
banks which have forced them to offer interest bearing deposits to garner low cost
funds.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
% Non Int Bearing Deposits
60%
50%
40%
30%
20%
10%
0%
1966 1970 1974 1978 1982 1986 1990 1994 1998 2002
(Data obtained from FDIC, Federal Reserve, BEA and MBA - $ in Billions)

Analysis of total laibilities
The following chart presents the composition of interest bearing liabilities for all
commercial banks. The weight of interest bearing liabilities have been on a
secular decline since 1984 falling from 85% in 1984 to 75% in 2003. This is
because banks have increased their reliance on fed funds and other liabilities
during the same period. This ties in well with the argument that with a slow
growth in deposits, banks have been forced to look at other funding avenues.
Trends in composition of
banking liabilities
% Wtg Int Bearing Deposits
% Wtg Fed Fund
% Wtg Sub Debt
% Wtg Other Liab
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90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
The following chart presents the trends in the cost of different liabilities of banks
during the period 1984 to 2003. Cost of subordinated debt and borrowed funds
have the highest cost and hence banks relying on these funds reflect pressure on
their interest margins. Cost of deposits and fed funds represent lowest cost
liabilities.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Int Bear Deposits
Tre nds in cost of liabilitie s
Total Deposits
16%
Fed Funds
14%
Sub Debt
12%
Other Borrow ed Funds
10%
8%
6%
4%
2%
0%
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: We expect slower deposit growth with the increasing flows in other
asset classes and mutual funds. Another reason for the slow growth is also the
absence of reversal in the personal saving rate. As a result of the existing
fragmentation in the industry and the intense competition, banks will have to
access other costly sources of funding. We expect that the cost of funds for the
banking industry will increase as a result of this.
Securities Portfolios:
Traditionally, banks’ securities portfolios have been an additional avenue apart
from loans and leases for banks to park their funds. This has acted as a buffer for
banks to maintain their profitability at times when the economy is in recession
and commercial and industrial loan growth is slow. However in recent times,
banks have been actively managing their securities portfolio to generate additional
revenue. Although most banks have traditionally invested in government or
government guaranteed securities, the last few years have seen a marked shift
from government securities to mortgage backed securities and asset backed
securities.
However the main question about the banks’ securities portfolio is the effect of
rising interest rates. Whereas the secular trends in the securities portfolio is
towards increasing durations, prepayment and extension risk caused due to the
higher proportion of MBS and ABS, the effect of rising interest rates on portfolio
values will depend on the kind of shift (parallel) and the timing of it. If we see a
parallel shift in the yield curve, which means that long and short-term rates rise by
the same extent, value of securities with longer dated maturities will fall faster
and thus adversely affect the securities portfolio of banks. However the effect can
be less pronounced if the short-term rates rise faster than the long-term interest
rates. For our analysis we will go with the assumption that banks’ will see a
decline in their securities values due to the rising interest rates environment.
However we do not predict any drastic decline as banks have become more
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
sophisticated in managing risks originating from interest rate and credit risk with
the use of derivatives.
Net Interest Margins:
The chart below presents the trends in the net interest margins for all commercial
banks from 1984 to 2003. There is a high degree of correlation between the
interest earned and paid by banks and the interest rate environment. Another
important trend that the chart conveys is that the net interest margins have
reduced significantly over time. Two main reasons have contributed to this. First
as we mentioned above, interest yields have faced pressure due to the decrease in
the banks’s share of commercial and industrial loans coupled with the growth in
the low interest yielding mortgage loan market. The second reason for this
declining margins is that the technological and infromational advances have
helped in a more efficent price discovery mechanism for deposit customers. The
consolidation of banks have also led to reducing monopoly for banks in their own
regions and hence forced them to offer competitive rates on deposits. Hence net
interest margins have been under tremendous pressure.
Conclusion: Net interest margins will continue to follow its secular decline for
the next five years. The only factor that can change our above prediction is that
the merger activity gains momentum and banks consolidate to gain supplier
power in different market segments on a demographic or geographic basis.
Net Interest Margins
19
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5.00%
4.50%
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Non Interest Income
The following chart presents the rise in the non interest income as a percentage of
earning assets. Non interest income as a % of earning assets increased from
1.25% to 2.87% till 1999 and then marginally dropped to 2.8% in 2003. This
secular increase is due to the increasing focus on banks on fee related income and
income from capital markets related activities such as fiduciary assets
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
management, trading revenues, investment banking and advisory fees etc. Banks
have been forced to look for profitable avanues as they face increased pressure on
net interest margins.
It is important to notice that the significant increase in non interest income is
almost entirely due to the increase in the other non interest income comprising of
captial market related revenues. These revenues have grown from 0.93% to 2.32
% during the period 1984 to 2003. The last three years however show a cyclical
decline from 2.44 % to 2.32 %.
Trends in Non Int Income
Other Non Int Inc as a % of Earning Assets
Fee Income as a % of Earning Assets
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: We expect that with the stagnancy in deposit account fee related
income, the non interest income will highly correlate with the capital markets.
We consider it a folly to predict the direction of the stock or bond markets for the
near term. However it is very clear from the secular trend that non interest
income will play an important part in the banks’ profitability. Keeping that in
mind we predict the non interest income to be 2.5% - 2.8% of earning assets for
the next five years.
Non interest expenses:
The following chart presents the trends in the efficiency ratio and its components
from 1984 to 2003. The efficiency ratio, which measures expenses per dollar of
revenues, is the key measure to guage the ability of the banks to manage its
operations efficiently. The ratio has been on a secular decline since 1984, from
68% in 1984 to 57% in 2003. From all the main components of the efficiency
ratio, the most remarkable decline has been in the employee expenses and
occupancy related expenses. All other expenses remained fairly constant during
the same period. There are three main reasons for the decilne in the overall
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
effciciency ratio and its components. The first being the advances in technology
has helped the banks to replace the traditional banking system (physical branches)
with ATMs, online banking and phone banking. Second, in general banks have
become more efficent in managing their operations which has helped in lowering
their expenses per dollar of revenues. However the third and most important
reason for this secular decline can be the consolidation in the banking industry. In
the past two decades the fragmented banking industry has seen considerable
consolidation, the driving force behind these mergers has been the synergies in
operations. Bank mergers have caused reduction in employees and closing of
branches and redundant operations.
Conclusion: With the reduction in the employees and branches being the key
driving force behind the merger trend, we can expect the employee efficiency
ratio and the occupacny effieicncy ratio to fall further in future.
II. BUSINESS, COMPETITIVE AND FINANCIAL ANALYSIS
To analyze the future business prospects of JPM (merged entity), it is important to
evaluate the historical financial trends of JPM and ONE, key industry trends and how
JPM and ONE fare against their peer group on key metrics. For our peer group analysis,
we chose Bank of America (BAC), Wells Fargo Bank (WFC), Wachovia (WAC) and
Citigroup (C) as all these companies are comparable in terms of asset size and diversity
in product offerings.
Now let us delve into each business segment of JPM and ONE and analyze, not only how
they have fared in the past but also how they are expected to fare in future as one entity
given the change in the business mix resulting from the merger.
1. Earning Assets:
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
The following charts present the trends in the composition of the earnings assets for
JPM, ONE and its peer group during the period 1992 to 2003. The peer group has a
higher exposure to loans and leases as compared to JPM and ONE. JPM’s exposure
to loans and leases has been shrinking since 1992 and is currently less than 50% of
total earning assets. While ONE’s exposure to loans and leases has been growing
during the same time period. Compared to this the loans and leases exposure for the
peer group has been steady at around 70%. Also looking at the increasing exposure
to fed funds and repurchase agreements, it seems like JPM has not been able to find a
profitable avenue to park its funds. ONE’s exposure to securities has been rising
since 1992 from 2% in 1992 to 24% in 2003.
Net loans & leases
Fed Funds and Repo
Securities
Interest-bearing balances
Cash and due from dep Instns
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
1992
1998
2000
03
20
00
99
01
20
20
19
98
19
97
19
95
96
19
19
94
19
19
93
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
92
1996
Net loans and leases
Fed funds and rev repo
Securities
Interest-bearing balances
Cash & due from dep instns
Net loans & leases
Fed Funds and Repo
Securities
Interest-bearing balances
Cash and due f rom dep Instns
ONE - Trends in
Earning Assets
19
1994
02
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Peer Group - Trends in
Interest Earning Assets
20
JPM - Trends in Int Earning Assets
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
By Bhavik Kothari
2002
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Conclusion: The merger will not make a significant difference to the combined asset
mix in the short run. Although the pace of JPM’s shrinking exposure to loans and
leases will be a reduced, JPM will continue facing a problem to find profitable
avenues to park its funds. Hence JPM will face a lower yield on earning assets and its
net interest margins will face further pressure.
2. Liabilities
The following charts present the trends in total liabilities for JPM, ONE and its peer
group during the period 1992 to 2003. JPM’s liability structure reflects a rational
decision on the part of the management to use fed funds as a low cost source of funds.
JPM’s weight of total and interest bearing deposits as a percentage of total liabilities
is far lower than that of its peer group. Its interest bearing deposits have decreased
from 55% in 1992 to 40% in 2003. Its non-interest bearing deposits too decreased
from 18% in 1992 to 14% in 2003. ONE’s deposits structure has not changed
substantially during the period under review. Its total deposits and the ratio of noninterest bearing deposits to total deposits have also not changed substantially. In
comparison to this, the peer group’s total deposits have marginally decreased from
77% of total liabilities in 1992 to 72% in 2003. However the ratio of non-interest
bearing deposits to total deposits seems to have increased over time.
JPM relies heavily on the federal funds and repurchase agreements for meeting its
funding requirements. Its exposure to the federal funds increased from 9% of total
liabilities in 1992 to 22% in 2002 and then decreased to 13% in 2003. Its exposure to
other liabilities also increased from less than 5% in 1992 to 26% in 2003. In essence
JPM’s dependence on high cost funds i.e. subordinated debt and other liabilities have
increased from less than 20% in 1992 to 30% in 2003 reflecting its inability to garner
low cost funds. ONE’s dependence on high cost funds in the past ten years is also
frightening. Other liabilities and subordinated debt make up 35% of ONE’s total
liabilities.
JPM - Trends in Liabilities
All other liabilities
Sub Debt and borrowed funds
Peer Group - Trends
in Liabilities
Fed Funds and Repo
Non Int Bearing Deposits
Int bearing deposits
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
All other liabilities
Sub Debt and borrowed funds
Fed funds and repos
Non Int Bearing Deposits
Int-Bearing Deposits
By Bhavik Kothari
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
ONE - Trends in Liabilities
All other liabilities
Sub Debt and borrow ed funds
Fed funds and repos
Non Interest-bearing deposits
Interest-bearing deposits
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: The merged entity will continue having a liability structure, which is
below par compared to its peers. The entity will continue to depend on high cost
funds and short-term funds. In such a scenario, the synergies from the interest cost
side do not appear to exist.
3. Income statement items:
Net interest Margins
The following charts present the trends in the interest yield and cost of funds for JPM,
ONE and its peer group for the period 1992 to 2003. The charts also present the net
interest margins for JPM, ONE and peer group for the same time periods. JPM’s net
interest margins have been declining from approximately 4% in 1992 to 2% in 2003
as compared to a steady margin of 4% for the peer group. Compared to that, the net
interest margins of ONE have been fluctuating between 2 – 3% during the period
1992 to 1999 and increased to 3% in 2001 and 2002 before falling to 2.5% in 2003.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
JPM - Trends in
Int Yield and Costs
9.00%
Yield on earning assets
Cost of funding earning assets
Net interest margin
Yield on earning assets
Cost of funding assets
Net interest margin
Peer Group - Trends in
Int Yield and Int Cost
10.00
8.00%
8.00
7.00%
6.00%
6.00
5.00%
4.00%
4.00
3.00%
2.00
2.00%
1.00%
-
0.00%
2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992
ONE - Trends in Int
Yield and Costs
2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992
Yield on earning assets
Cost of funding earning assets
Net interest margin
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: A combined entity with low earnings yield on assets and high cost funds.
Synergies, both on the interest earned side and interest cost side are missing and
hence any near term catalysts fail to appear. The combined entity will continue
having a net interest margin lower than that of its peer group at least for five years.
Non Interest Income:
The following charts present the trends in the non-interest income as a percentage of
earning assets and its composition for JPM, ONE and its peer group from the period
1992 to 2003. The charts reflect that JPM’s non-interest income as a % of earning
assets has been close to that of its peer group (3% in 2003). However, ONE’s net
interest income declined from 3.7 % in the year 1993 to 1% in the year 2000 and then
rose to 2% in 2003 still a 100 basis points below that of the peer group. When
analyzing the components of non-interest income, we find that JPM generates a
higher percentage of revenue from fiduciary activities and trading profits as compared
to its peer group. However the peer group generates a higher percentage of noninterest income from deposit account fees and other non-interest income. As
compared to that, most of ONE’s non-interest income contribution is from additional
non-interest income and service charges on deposit accounts.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
It is important to note that JPM has a higher reliance on revenues that are dependent
on the capital market activity. Revenues such as trading profits, asset management
fees, investment-banking fees etc are highly volatile and correlate with the economic
activity and capital markets.
Addn non int income
Trading gains & fees
Service Chgs on Deposits
Fiduciary activities
JPM - Non Int Income as
a % of Earning Assets
3.50%
Peer Group - Trends in
Non Int Income
3.50%
3.00%
3.00%
2.50%
2.50%
2.00%
2.00%
1.50%
1.50%
1.00%
1.00%
0.50%
0.50%
Addn Non Int Income
Trading gains
Service chgs on deposits
Fiduciary activities
0.00%
0.00%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
ONE - Trends in Non Int Inc
as a % of Earning Assets
4.0%
3.5%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Addn non int income
Trading gains & fees
Service Chgs on Deposits
Fiduciary activities
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: The non-interest income of the combined entity will fall below that of its
peer group because of the lower level of ONE’s net interest income. However the
combined entity will have a diverse mix of non-interest income and will have lesser
reliance on capital markets activity, than before. Synergies might be possible in the
stability of the revenue and the ability of the combined bank to cross sell its different
products to a larger client base. Although it is difficult to accurately predict the effect
of synergies on the future non-interest income, we can safely assume that the noninterest income of the combined entity will average around 3% for the next five years.
Efficiency Ratio
The efficiency ratio reflected in the charts below present a dismal trend for JPM as
compared to its peer group. Its efficiency ratio increased from 62% in 1992 to 84%
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
in 2002 and fell to 70% in 2003. In comparison to that, the peer group saw an
increase in its efficiency ratio from 64% to 73% from 1992 to 1998 before declining
to less than 60% in 2003. The volatility in the efficiency ratio mirrors the volatility in
the non-interest revenues (denominator for the calculation of the ratio). ONE’s has
done an exceptional job in managing its operations. Its efficiency ratio, which was
higher than 90% in 1992 decreased to 75% in 2000 and further decreased to 60% in
2003. Although in 2003, its efficiency ratio is slightly higher than the peer group, the
ability of the bank to drive down costs and improve its operations speaks well about
the future.
Now let us analyze each of the components of the efficiency ratio. In case of JPM,
the employee expenses ratio and the occupancy expenses ratio has seen a secular
increase since 1992. The employee efficiency ratio increased from 30% in 1992 to
36% in 2003. The occupancy efficiency ratio increased from 11.5% to 15.4% during
the period 1992 to 2003. These expenses have been the main contributors for the
surge in the over all efficiency ratio. In comparison to that, ONE’s employee
efficiency ratio dropped from 37% in 1992 to 19% in 2003. ONE’s occupancy
expense, which was 18% in 1992, decreased to 6% in 2003 a considerable drop.
In comparison to this the employee efficiency ratio and the occupancy efficiency ratio
of the peer group has been on a secular decline during the period 1992 to 2003.
JPM - Trends in Efficiency Ratio
Other Exp Eff Ratio
Occupancy Exp Eff Ratio
Employee Eff Ratio
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Peer Group - Trends in
efficiency ratio
80%
Other Exp Eff Ratio
Occupancy Exp Eff Ratio
Employee Eff Ratio
70%
60%
50%
40%
30%
20%
10%
0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
ONE - Trends in Efficiency Ratio
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Other Exp Eff Ratio
Occupancy Exp Eff Ratio
Employee Eff Ratio
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Conclusion: We expect that the increasing trend of JPM’s efficiency ratio will be
arrested as a result of the merger. We expect that the new COO of JPM unanimously
considered the driving force behind ONE’s improving operations, will be able to run
the merged entity in an efficient manner. Hence the efficiency ratio of the combined
entity will fall and average out at 55% - 60% in the next five years as a result of the
efforts of the new management in capitalizing on the expected synergies.
Loan loss reserves:
The following chart presents the trend in the loan loss reserve as a percentage of total
loans outstanding for JPM, ONE and its peer group for the period 1992 to 2003.
Historically, JPM’s loan loss ratio has been close to its peer group. ONE’s loan loss
ratio was lower than that of JPM and the peer group from the period 1992 to 1999 and
then higher from 2000 to 2003.
Conclusion: Loan loss ratios are highly volatile and difficult to predict. Generally
higher provisions are made during recessions and loan loss ratios fall during periods
of economic progress. With the current loan loss ratio of the combined entity being
1.7%, for our calculations, we will use a conservative 2.5% loan loss ratio for the next
five years. This represents the historical trend observed when the economy has been
able to achieve a stable and sustained progress.
Trends in Loan Loss Allowance
as a % of Total Loans
Loss allowance to loans - JPM
Loss allowance to loans - ONE
4.50%
Loss allowance to loans - Peer
Group
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
02
01
00
99
03
20
20
20
20
19
98
19
97
19
96
19
94
95
19
19
93
19
19
92
0.00%
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
Return on Assets and Return on Equity
The following charts present the trends in the return on assets and return on equity for
JPM, ONE and the peer group during the period 1992 to 2003. In the past 11 years,
JPM and ONE, both have had their ROA and ROE lower than that of its peer group.
While JPM’s ROA and ROE have been fairly stable in the past 11 years, ONE’s ROA
and ROE have been highly volatile.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Trends in ROA
JPM - Return on assets (ROA)
2.00%
ONE - Return on assets (ROA)
Peer Group Return on assets (ROA)
Trends in ROE
JPM - Return on equity (ROE)
ONE - Return on equity (ROE)
Peer Group - Return on equity (ROE)
25.00%
20.00%
1.50%
15.00%
1.00%
10.00%
0.50%
5.00%
0.00%
0.00%
-5.00%
-0.50%
-10.00%
03
02
-25.00%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
20
01
20
20
00
20
98
97
96
95
99
19
19
19
19
19
19
19
19
94
-20.00%
93
-15.00%
-1.50%
92
-1.00%
(Data obtained from FDIC, Federal Reserve, BEA and MBA)
III. VALUATION ANALYSIS:
Equity research is like a suspense novel. You don’t know what is going to happen
until the above analysis and assumptions are incorporated as inputs to arrive at a fair
valuation of the company using different valuation tools.
Before we begin to delve into the valuations using our valuation models let us take a
step back and understand the method of computation of cost of equity for the merged
entity.
Calculation for Beta and Cost of Equity
JPM
BETA - (regressing historical
returns of the companies against
that of S&P 500
Risk Free Rate (91 day T bill rate)
Market Premium (over the risk
1.387235
1.36%
5.00%
ONE
1.243238
1.36%
5.00%
Cost of Equity
8.30%
7.58%
Shares Outstanding before
2,042
1,111
Market Price before merger (June $
38.43 $
51.00
Market Value (millions)
78,474.06
56,661.00
Weighted Average Cost of
EquityBeta (market value
Add: Derivatives Risk
Cost of Equity for the merged
7.99%
0.50%
8.49%
To calculate the cost of equity for the merged entity we first regressed each individual
companies’ historical returns with that of the S&P 500 and calculated the individual
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
beta. Then using the beta, the current three-month t-bill rate and the historical market
risk premium of 5%, we calculated the cost of equity for individual companies using
the CAPM. We then used the market values of both companies on the date of the
merger and calculated a weighted average cost of equity using the market values as
weights. Considering that JPM has a significantly high exposure to derivatives
contracts than a typical bank, we considered it appropriate to conservatively add 50
basis points to the cost of equity. Although we would like to believe that the
derivative risk is already built into the stock specific risk, these contracts carry huge
event risk (of which the expected probability is very low and might not have taken
place yet), which the markets might not have recognized. Hence the additional 50
basis points. With this method we get a cost of equity of roughly 8.5%.
Now let us determine the valuations using three models; the dividend discount model,
the Diamond Hill Investment Model (see note below) and the comparables (PE and
PB) model. All the key inputs to the models such as earnings and dividends are
based on the projected financial statements (refer appendix at the end of the
report). Although these models act as a starting point to gauge valuations, we are
aware of the fact that models are only as good as the inputs that go into these models.
Hence it is also critical to examine the sensitivity of the valuations to the inputs.
J P MORGAN AND BANK ONE (MERGED ENTITY) - VALUATION AS PER THE DIVIDEND DISCOUNT MODEL
Cost of Equity
8.49%
( in $ 000s)
2003
Net income
Cash dividends
No of Shares Outstanding
Earnings per Share (in $)
Projected Earnings Growth Rate
Dividends per Share (in $)
PV of Dividends
Cumulative PV of Dividends
Terminal Value
Discounted Terminal Value
Intrinsic Value
2004 (1st
half)
2004 (2nd
half)
7,215,000
3,848,000
3,153,000
2.29
4,808,953
2,885,372
3,508,520
1.37
4,808,953
2,885,372
3,508,520
1.37
0.69
0.82
0.82
0.79
2005
2006
2007
2008
11,933,564 12,933,008 14,920,786 16,986,318
7,160,139
7,759,805
8,952,472 10,191,791
3,508,520
3,508,520
3,508,520
3,508,520
3.40
3.69
4.25
4.84
24.08%
8.38%
15.37%
13.84%
2.04
2.21
2.55
2.90
1.81
1.80
1.92
2.01
> 2008
4.99
3%
2.99
8.33
54.46
34.78
43.11
The above table presents the valuation of JPM (merged entity) as per the dividend
discount model. We calculated the dividend flows for the next four and a half years
based on the forecasted earnings growth rate (for the detailed historical and forecasted
financials and key statistics please refer the appendices) and a terminal growth rate of
3%. Based on the above analysis, the intrinsic value of JPM comes to $43.11. The
intrinsic value thus calculated is highly sensitive to the cost of equity and growth rate
assumptions. Following are the results.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
SENSITIVITY OF THE VALUATION FROM DIVIDEND DISCOUNT MODEL TO KEY
ASSUMPTIONS
Terminal Growth Rate
Cost of Equity
7%
8%
9%
10%
11%
2%
49.51
40.78
34.57
29.94
26.36
3%
60.22
47.63
39.27
33.32
28.88
4%
5%
78.07
57.90
45.84
37.82
32.13
113.78
75.02
55.69
44.13
36.45
The values ranged from $ 26.36 at a growth rate of 2% and a cost of capital at 11% to
$ 113.79 at a growth rate of 5% and a cost of capital of 7%. We believe that a cost of
capital at 8.5% and a growth rate of 3% is a conservative estimate and we feel
comfortable with this assumption.
Diamond Hill Investment Model
The following table presents the valuation of JPM using the Diamond Hill Investment
Model (DHIM). The DHIM (see note below) is a variant of the dividend discount
model. Similar to the two-stage dividend discount model used above, the DHIM aims
at calculating the dividends for the next four and a half years and then adds a
discounted terminal value based on a terminal PE assumption. The terminal PE is
based on the assumption that valuations revert half way to a mean PE of 15. In JPM’s
case the current PE is 15.11 and hence the terminal PE is (15.11 + 15)/2. The model
uses 15 as a mean PE for two reasons. The first reason is that in the past 100 years
the average trailing PE of the stock market has approximately been 15. The second
reason is that if a company has a higher valuation (PE), then over a period of time
when the growth matures or competition kicks in, the growth will slow down and
valuations will revert to the mean.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
J P MORGAN AND BANK ONE (MERGED ENTITY) - VALUATION AS PER DIAMOND HILL INVESTMENT MODEL
Cost of Equity
8.49%
( in $ 000s)
2003
7,215,000
Net income
3,848,000
Cash dividends
3,153,000
No of Shares Outstanding
2.29
Earnings per Share (in $)
Projected Earnings Growth Rate
0.69
Dividends per Share (in $)
PV of Dividends
8.33
Cumulative PV of Dividends
$
38.00
Market Price (as on 8/19)
15.11
Trailing Twelve Month PE
Expected Terminal PE [(Curr PE +15)/2] 15.06
Terminal Value (Terminal PE *
EPS at yr 2009)
Discounted Terminal Value
47.95
56.28
Intrinsic Value
2004 (1st
half)
2004 (2nd
half)
2005
4,808,953
2,885,372
3,508,520
1.37
4,808,953
2,885,372
3,508,520
1.37
0.82
0.82
0.79
2006
2007
2008
11,933,564 12,933,008 14,920,786 16,986,318
7,160,139
7,759,805
8,952,472 10,191,791
3,508,520
3,508,520
3,508,520
3,508,520
3.40
3.69
4.25
4.84
24.08%
8.38%
15.37%
13.84%
2.04
2.21
2.55
2.90
1.81
1.80
1.92
2.01
4.99
3%
2.99
75.08
The main advantage of this model is that unlike the dividend discount model, we do
not need a constant growth rate assumption. As per this model we arrive at a value of
$ 56.28 for JPM.
SENSITIVITY OF THE VALUTAITON FROM DIAMOND HILL INVESTMENT MODEL TO KEY
ASSUMPTIONS
Terminal PE
Cost of Equity
7%
8%
9%
10%
11%
> 2008
13.00
14.00
15.00
16.00
17.00
52.91
50.68
48.58
46.60
44.74
56.34
53.94
51.68
49.55
47.55
59.78
57.21
54.79
52.51
50.36
63.22
60.47
57.89
55.46
53.16
66.65
63.74
61.00
58.41
55.97
The above table presents the sensitivity of the valuation to the cost of equity and
terminal PE assumptions. We believe that the above range of values makes us feel
comfortable about our analysis. Plus the values arrived as per the DHIM are not as
sensitive to assumptions as the ones arrived at with the dividend discount model.
Again of these, a worst-case scenario of a terminal PE of 13 and a cost of equity of
9% gives an intrinsic value of $48.58, which is higher than the current market price of
$ 38.00.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Comparables model:
Regression Analysis
Price to Book Ratio
3.50
y = 0.0799x + 0.8172
R2 = 0.4665
3.00
2.50
2.00
1.50
1.00
0.50
0.00
0
5
10
15
Return on Equity
20
25
We regressed the ROE and Price to Book Ratios of JPM, industry average and 12 other
banks to observe any correlation between these two statistics. We found that there is
some correlation between the ROE and the price to book ratios of banks. Although the R
Square for this regression was not high (0.46), that might be because of the fewer number
of observations. There is a logical explanation for this relation.
As per the dividend discount model:
Price = DPS Yr 0 *(1+G)
R-G
There fore: Price = EPS Yr 0 * payout ratio * (1+G)
R-G
Hence: Price = Book Value * ROE Yr 0 * Payout ratio * (1+G)
R-G
Hence: Price/ Book Value = ROE Yr 0 * Payout ratio * (1+G)
Using the regression equation obtained as per above: The calculated Price to Book Ratio
for JPM = 0.8172 + 0.0799 * 10.72 = 1.67 which is lower than the current price to book
ratio of 1.74.
Hence as per the comparables method of valuation, the valuation of the stock is 1.67 *
21.52 (Book Value per share) = $ 36.12
Analysis of the models:
Based on the three methods of valuation that we just used, our measurements of intrinsic
values have ranged from as low as $ 36.12 by the comparables method of valuation to as
high as 56.28 using the DHIM. We also got $ 43.12 as per the Dividend Discount Model.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
We believe that the valuation using the comparables method of valuation helps us set the
floor of the intrinsic value. The reason being that this method of calculation uses the
current ROE of JPM and not the change in ROE, which can act as a key driver to stock
prices. With the synergies in operations and a stable revenue base we expect that the
ROE will increase during the next five years (refer to financials).
The valuation as per the dividend discount model is very sensitive to the terminal growth
rate as we have seen before and valuations as per this model have a wide range highly
sensitive to the growth rate assumption. In such a case we would hesitate to base our
investment decision based on this model.
The Diamond Hill Investment Model does not assume a terminal growth rate and is not
very sensitive to the PE and cost of equity assumptions. Valuations as per this model
have ranged from $ 44.74 to $ 66.65 a much narrower range than that as per the dividend
discount model. The model also takes into consideration the lowering of valuations in
the five years time, which again helps us arrive at a conservative estimate. Hence we
believe that the DHIM does a better job at ascertaining the intrinsic value of the stock
than the other two models.
Conclusion:
Based on the above valuation analysis, we believe that JPM is trading at a significant
discount to its intrinsic value. Based on the intrinsic value of $ 56.28, the stock is trading
at a significant discount with a margin of safety of 33% approximately. {(Intrinsic Value
/ Stock Price) – 1}. Hence we recommend that JPM is an attractive BUY opportunity at
the current stock price with minimal risks and a stable industry.
1.
“The declining number of US Banking Organizations: Will the trend continue?” Kenneth D.
Jones and Tim Critchfield - FDIC Website www.fdic.gov
Note on the Diamond Hill Investment Model:
The DHIM provides a framework by which to analyze the valuation of a stock, and allows the analyst
flexibility to input earnings and the expected growth rate of those earnings, as well as the necessary riskadjusted discount rate. The flexibility to overlay individual judgment regarding such issues as translating
accounting earnings into economic earnings, incorporating recent developments, and factoring in
qualitative information, leads each user to a conclusion based on their own scenario. (Note: The model
requires a good understanding of financial and mathematical terminology and therefore is designed for
users with an educational or professional background in finance.)
http://dhim.diamondhill.com/list.asp?ticker=&start=0&perPage=50&query=alphaover5&sctr=&ind=INV%20BANK%20%D8
%20BROKERAGE&sort=tblInvest.Ticker
For questions about this web site contact Ric Dillon at 614.255.3355.
© 2001 Diamond Hill Capital Management, Inc. All Rights Reserved.
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Appendix I:
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Appendix II:
By Bhavik Kothari
August 20, 2004
Fisher - Equity Research
________________________________________________________________________
Appendix III:
By Bhavik Kothari